Tuesday, July 21, 2009

Mutual Funds Explained: What Do Mutual Fund Directors Do?

If you listen to John Bogle, founder of the Vanguard group and index fund advocate extraordinaire the answer is not enough and not enough for the money they are being paid. While index funds need little in the way of director input and the manager need only track the index they are assigned, actively managed mutual funds are a different story.

Mutual fund directors are supposed to be independent of the fund family they work for and the managers they oversee. They have enormous fiduciary responsibilities and some take this very seriously. Some, not so much.

There is the possibilities that those who do a job that is not in the shareholders best interest may be compromised by the not only the amount of money they earn from each fund board they sit on but the sheer number of funds they are charged with overseeing.

Bogle raised some eyebrows when he compared the average salary of a board director in the corporate sector ($48,000 per year per board - many who qualify sit on numerous boards) and those in the mutual fund industry ($386,000 per year per board - nearly eight times the corporate average). He more or less called this kind of pay disparity bribery suggesting that the director could not possibly do his job effectively with those kinds of compensation packages being doled out by the fund family.

In essence, Bogle suggested that the director, rather than working for the shareholder is merely a fund manager's stamp of approval. Can a mutual fund director do his job effectively without jeopardizing his lucrative compensation?

Possibly. But could someone like Lee A. Ault, 73, whose name turned up in 371 SEC required filings in the past year? Possibly not. The answer is left to the SEC. Currently, the level of responsibility that these fund directors must assume is really quite low. New regulations would allow the directors to better monitor decisions and performance, set fees that do not unduly impact the returns of the shareholders and keep track of how soft money is spent.

Thursday, July 16, 2009

Mutual Funds Explained: Why Portfolio Turnover Matters

I discuss in my book, Mutual Funds for the Utterly Confused (McGraw-Hill 2008), the differences between the various expenses that impact an investors interest and return in a mutual fund. Among the sneakiest of these fees, is the turnover ratio. Why do investors still use funds that consistently report high turnover of the stocks in the fund's portfolio can be answered two ways. But first, what is a turnover ratio and how is it determined?

The Turnover Ratio is the result of the fund manager repositioning the portfolio. This is done much more often in a growth fund, where the manager may be looking for fund appreciation and to take advantage of this, they must sell some of what they hold in order to buy stocks that they feel will benefit their shareholders.

To determine the ratio on your own, investors will need to divide the value of both the purchase and sale transactions for the period by two and then, divide that figure by the total holdings of the fund. The higher the trading activity, which usually takes place in a growth fund more than in a value fund, the higher the turnover ratio.

If the turnover ratio is 100%, the fund has changed the underlying portfolio completely over the given the period. Less than 100% turnover, the fund's expenses for trading are lower than a fund that has exceed that number. Questions is: why would a fund manager trade so much if they knew that the cost of this activity creates a tax implication (in a retirement account, this tax consequence is deferred until you actually begin to draw on the funds)?

There are several reasons. New managers, of which there are many new faces in the mutual fund world after 2008, like to find better opportunities than their predecessors. Older managers may be attempting to restructure their portfolio to take advantage of newer opportunities that would redeem their fund's less than stellar performance during the height of the downturn. neither of these reasons though are very good.

You pay for research and subscribe to a charter (what your fund's investment focus is) and expect your fund manager to use these costs wisely. A high turnover ratio basically puts the spotlight on poor decisions followed by poorer, more costly revisions of those decisions. The higher the turnover, the more these managers have ignored research offered by their fund family or found that what you already paid for was somehow flawed. The higher the turnover ratio, the greater the resemblance a fund manager has to a day trader.

Even in a growth fund, these costs can be kept down and thoughtful and prudent trading can help a great deal. Believe it or not, there is a limited number of stocks available at any one time. To buy, you need a seller. As all investors know, the seller must know something that the buyer does not. In the small-cap arena, the number of stocks is much smaller because of liquidity (the number of shares available at any one time). Too few shares means that nay activity will drive the price up on the share price, create unnecessary costs, and in many instances, void any potential the stock might have in the near future.

This doesn't mean you should run for an index fund or even a value fund just because of fees. It does pay to consider them though and whether the fund's performance will be great enough to overcome the higher costs.

In a fund held outside of a retirement account, turnover ratios are essentially a taxable event (selling something profitable always creates taxes) and this is often taxed at the short-term rate. If you are using growth fund in your retirement portfolio (and I highly recommend that this is where they should be held) this tax is deferred. But that is not a reason to hold a fund that turns over its portfolio too much in any given period. For a growth fund, the portfolio turnover should not exceed 50-75%. If it exceeds this, something might be wrong.

Be sure to check out our all important examination of why investors do what they do.

Monday, July 13, 2009

Mutual Funds Explained: Prepping for the Third Quarter and Beyond

No market appreciates the beginning of a new quarter when it coincides with a holiday. No market enjoys bad economic news either. So, as earning season begins on Wall Street, a time of speculation, expectations and often dashed hopes and dreams, I want to take a moment and cover some of the behaviors that investors need to come to grips with.

Our sister blog has been reviewing some of the investor habits that are worth noting. You have just watched the recovery of many of your mutual funds, especially of you were not in index funds but allocated in growth both domestically and abroad.

Before You Buy: Why Investors Do What They Do

Loss Aversion begins the discussion with "Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made."

Investors are also guilty of narrow framing. "Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk."

Many of our beliefs about investing revolve around another bad habit: anchoring. Investors "may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring."

Mental accounting affects how we invest as well. "Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past."

Diversification is not what you think it is. "These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In the first part of 2008, billions of dollars were being invested in a market near it top. In the second half of 2008, billions were withdrawn. This is herding at its best and worst. "It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder."

And then there is regret. "One of the basic assumption in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret."

Nothing has impacted your investment style and direction and is in fact least suited to do so, than the media. "Has the hype in the media over the last several months had an effect on how your invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television."

And lastly, there is optimism, that feel good, I want to invest emotion that often gives us reason to engage in all of the previously mentioned investor behaviors. "In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior."

So before you get back into a market (that I hope you never left), take the time to examine the investor in the mirror.

Friday, July 10, 2009

Mutual Funds Explained: Measuring Mutual Fund Performance Using a Rolling Average

In a previous post on performance, I wondered if there was a way for investors to measure how well a mutual fund has done. Mutual fund managers often use comparison to less risky indexes as the benchmark for their own performance. This, we all know, enhances how the fund appears to have done. Right or wrong, I suggested that the ultimate guide to performance may lie in the investor; the person in the mirror who must assess their risk, their goals, and their expectations.

Richard Gates, portfolio manager for TFS Capital agrees. Interviewed recently at Forbes, he said: "I think the root of the problem is not really how returns are measured and presented. Rather, I think the basic problem is that investors just shouldn't be so fickle about short-term performance." And that accounting of performance is what we are faced with, almost daily.

The short-term also presents other problems. For instance, how can you tell whether a mutual fund manager simply has lost her/his/their touch even as the market declined for every fund? In other words, is bad really the fund manager's fault? Or is doing bad something entirely different?

It would be nice to throw 2008 out of the equation. But for the next five years, that year will show every fund as underperforming even as we forget about what happened in 2008, probably soon after we turn the calendar on 2010. The real test is how well they have done since March of this year (2009). But that would be looking to the short-term in the hope of finding some long-term potential. Is it possible?

Is it right to do so? Possibly not. If you are an investor, 2008 looked really bad. Yet, never have investors had such a clear understanding of what worst-case scenario looks like. Bear markets toughen investor hides across the board. Sure, many run for cover. But those that understand that bad can be turned into good, relish the opportunity to grab a once in a lifetime (or perhaps once in a five year cycle would be more like it) chance at finding out what worked and what didn't and even more importantly, why.

Keep in mind, even as funds fell, so did their comparable benchmarks. Were they still able to match, even beat those benchmarks in a down year? Did the fund family pursue a cost-cutting, fee stripping strategy to help boost your return, however meager? Did they look out of house for a different manager to run a fund that was really beaten down?

If your fund manager is still at the helm as I write this, look at their performance over the past ten years to get what is called a rolling average. Compare that number with the benchmark's rolling average over the same period. Then compare it to the peer group, using the same investment style as a comparison.

Then look at your risk factor again. The investor in the mirror will need to make some choices as well. And whatever you do, do not eliminate too much risk. Let your fund manager do what he can to mitigate out-sized risk as they struggle to regain your confidence and at the same time, increase their performance.

Tuesday, July 7, 2009

Mutual Funds: Some Terms, Some TIPS, Some Bond Funds

Let's take a moment and clarify a few terms. Lately, investors and non-investors have heard some terminology being batted around, much of which all sounds the same. Inflation, deflation, hyperinflation, disinflation, stagflation. What do they mean and how do they ultimately effect your investments? Are TIPS the answer? Are bond funds protected?

We are all familiar with inflation. The term simply means that as long as your dollar stays in your pocket (or in the cookie jar or stuffed under the mattress) it is losing value. Often expressed as a percentage, it relates to the buying power of your money. In other words, if inflation is at 3% (for example) your dollar is actually worth less and when you eventually do decide to spend it, you will have to pony up an additional three cents to cover the costs.

Deflation is the opposite of inflation and much more troublesome. To be in deflationary environment is to see prices falling because there is no spending. Unemployment might be the cause. Tight credit might be the cause. Lack of government spending might also contribute. It has a spiraling downward effect that can be hard to change. Once folks stop spending, stop borrowing and basically hunker down, businesses react by layoff workers and producing less. Incomes shrink and the economy tanks. The Federal Reserve usually steps in making money available to borrow and increasing the supply of money available. Sometimes this is all that is needed; sometimes, as in the case of Japan in the nineties and through to 2006, it does not.

Disinflation is not to be confused with deflation. It is actually a good thing in many instances and can signal a reduction in inflation rates, which has the net effect of increasing the worth of the dollar in your pocket.

Hyperinflation is basically runaway inflation. The economy is out of balance. The country's currency has no real value and the balance between supply and demand is thrown out-of-whack.

Stagflation occurs when prices rise as manufacturers attempt to continue to profit but the job's market doesn't improve with those price increases. High prices and unemployment make for an unsavory pair and the result fo this often triggers inflation as well. When oil prices rise for instance but the economy has not provided enough jobs to absorb the increases, stagflation is often cited as the problem.

In tough economic times and with scary terms like the aforementioned get tossed around, investors look for some safety. Treasury Inflation Protected Securities are often where folks turn to cover their assets.

TIPS protect your principal and pay you a dividend (or coupon) every six months. That coupon is adjusted for inflation based on the Consumer Price Index or CPI. This is a survey of goods and their costs used to determine how much these items impact the average income.

And although this sounds like a good way to protect your money, the best way to do it is to buy those TIPS individually and not through a bond fund or ETF. Prices on these types of securities do change and you may lose money when you buy them in a fund.

Mutual funds will try to find bonds in which to invest. And while this is better achieved through a fund - they get better prices and are able to spread the risk among varying maturities - buying TIPS this way is not one of them.

Monday, July 6, 2009

Mutual Funds: Measuring Performance May Not Be Worth The Effort

Point A to Point B. Simple. Clean. Understandable. Investing is none of that yet it is more or less how we approach the subject. This is particularly true of mutual fund investing, where performance falls at the top of the list. Unfortunately, it may not be as measurable (even worth measuring) as we had thought.

The Mirror Effect
Mutual fund investors often fail to correlate the actual returns on their investments for two reasons. The portfolio they own is subject to constant investment and sometimes, if the fund is held outside of a retirement account, withdrawals. The return on your mutual fund statement does not reflect any of those transactions. Instead, it would mirror your portfolio had you done nothing at all.

This of course is virtually impossible to do. Oliver L. Velez and Greg Capra identify this mirror effect in their book "Tools and Tactics for the Master Day Trader" when they write: "Every consistently losing trader sees the market as this angry foe that must be overcome, tricked or even conquered. In the loser's mind", they warn begins to believe "the market is out to get them."

They point out that once this begins to dominate the traders mind, "the market, being the perfect mirror that it is, cast that very perception back, in every detail." The winning trader ironically sees the same market differently, not surprisingly as friendly, warm and welcome, willing to bend to her/his every move.

Measuring Mutual Fund Performance
We have looked at numerous ways to determine a mutual fund's performance from weighing the manager's tenure and experience against a group of his peers. Newer managers realign portfolios and attempt to regain investor confidence with their skills mostly designed to gain in the short-term. But often what they do is lumped together and left to the investor to sort out.

Mutual funds are often guided by a charter that we have all found, is only a loose interpretation in many cases of exactly where the fund is headed. Barriers between growth and value styles of investing drop and the blurry boundaries between what is a mid-cap and what is a small-cap, what is a large-cap and what is a mid-cap, often add to the confusion. Last minute window dressing at the end of a quarter also creates a distortion that the average investor often cannot measure. Most professionals have a difficult time with "noise" as well.

One other thing that cannot be successfully unraveled is the relationship between luck and skill in the fund manager's results from one year to the next, one quarter to the next. In many cases, there is simply not enough time to make good judgments even though a decision must be made. So comparisons must be made and this is where the errors begin to surface. Most funds will chose a measurement that carries less risk and therefore less in potential returns.

This is the point in the discussion where you come down on one side or the other. Many market measurements still point to the success of index fund investing over actively managed funds. In the long-term, indexes do win. But they win because they are tax-efficient and because they cost less.

Here is the problem. If you are investing in a tax-deferred account, the chances of winning in a more actively managed fund, one that is reexamined each year for performance and expectations should provide you with a better need of the working cycle return that an index fund in the same place. Actively managed funds take more work while index funds do not. But removing risk does not replace returns evenly. And in many cases, fees have also dropped considerably as well.

To measure how well your fund is doing, perhaps the only way that you can successfully do it means that you should look in the mirror first and ask yourself the same question.

Thursday, July 2, 2009

Mutual Funds: Rookie Mistakes

Beginning investors are often confronted by numerous descriptions of what mutual funds actually are. Some have even gone so far as to suggest that "A mutual fund is simply a firm that collects money from investors and invests them on stocks, bonds, and other money market instruments. If you invest in one, you will be considered a share holder and your portfolio will consist of a diverse investment."

This is a very simplified description of what mutual funds are. Consider this: a mutual fund is an investment whereby like-minded individuals (those who are looking for the same exposure to risk) hire a mutual fund manager who focuses on those investment goals and seeks to grow their money. Yes, they are shareholders. But unlike folks who buy individual stocks or bonds, they only own a portion of the investment with the group rather than owning a voting share.

You will also find that numerous financial planners and professionals also oversimplify the process by touting Fidelity or Vanguard, both of which are too big for their own good as the simplest way to enter this type of investment. This overlooks numerous other funds that do just as good a job, often at a lower entry fee and with better strategies.

Index funds, such as Vanguard's 500 can be less expensive fee-wise than most of its rivals but the $3,000 to get started will keep most beginners away.

Beginning investors (who are buying funds for their retirement, a tax-deferred situation that is best suited for actively managed funds and not for passively managed ones like indexes) should look to actively managed funds for low fees and expenses compared to their peer group, managers with tenure and low entrance fees. Index funds should be kept outside of tax-deferred plans due in part because they create no real taxable situation that would be worth putting off until the future - considering the capital gains tax for long-term investors is still low and worth paying as you go.